Dispatches from a Small Business

So Just What Was the Omitted Intervention

In a post earlier today on the mortgage market meltdown, I wrote:

And that is what the argument usually boils down to - someone smart
should have been watching them. But lots of smart people were watching
all the time. You can see one such person featured in Lewis's
article. Guys run all over Wall Street looking every day for some
single digit basis point spread they can make money off of. But untold
wealth was just sitting there for someone who was willing to call
bullshit on the whole CDO/CDS pyramid game. These guys playing this
game were searching for people to bet against them.

And
despite this, despite untold wealth as an incentive, and companies
looking for folks to take the other side of their transactions, only a
handful saw the opportunity. Thousands of people steeped in the
industry with near-perfect incentives to identify these issues ... did
not. What, then, were our hopes of having some incremental government
bureaucrats do so? Usually, after this kind of crisis, there are lines
of pundits and writers ready to suggest, with perfect hindsight, new
regulations to avert the prior crisis. But, tellingly, I have heard
very few suggestions.

So in this context, I found these comments by leftish Kevin Drum, certainly no knee-jerk advocate of free markets, quite interesting:

No argument on the greed and ideology front, but I'm curious: was
there really anyone who made the right call on all this at a policy
level? There were, of course, plenty of people who recognized the
housing bubble for the idiocy that it was (Alan Greenspan notably not
one of them), but were there any major voices making specific policy
proposals to slow down the bubble? Or rein in the mortgage market? Or
regulate the CDO/CDS market in a way that would have prevented some of
the damage? I'm talking specifics here, not just general observations
that the FIRE sector was out of control. Arguments about interest rates
being too low count, if they were made for the right reason, but I'm
interested mainly in more detailed recommendations.

I don't have any big point to make here. I'm genuinely curious. There were
many moments in the past few years when perhaps something could have
been done, but what? And who was proposing serious measures that would
have helped? Any major Dems? Economic pundits? Wall Street mucky mucks?
Who were the unsung heroes? Help me out here.

Comments

As usual, look no further than Ron Paul.

Paul of course was asking to make it illegal for the Fed and for FMAE/FMAC to be joined at the hip the way they were. He introduced a bill to make it illegal for the Fed to operate on GSE debt instruments. Like most things he wants, it never went anywhere.

He has been quite consistent on what the root causes were - Federal manipulation of the financial and especially mortgage sector, and the implict backing of mortgages by Uncle Sam. He's tried to restrict this, outlaw it, get rid of the Fed's inflationary powers -- all kinds of things that would have both put a damper on the magnitude of the problem _and_ made its cleanup more plausble for the government to stay out of.

Posted by: Matt | Nov 13, 2008 2:53:45 PM

In a roundabout way, the fact that so many smart people missed this call is a persuasive argument for limited government. All these little tweaks to the basic system have made it virtually impossible to predict *any* outcome. In fact, I'll bet most economists still aren't sure there's actually a crisis that requires massive intervention in the economy. Maybe all the distressed banks, brokerage houses, insurance companies, and unsold real estate will be bought at firesale prices by people who were smarter (or luckier) with their money, and the whole problem will go away by itself. We just don't know.

So maybe the solution is to stop adding layer upon layer of complexity and go back to simpler business models (you know, like banks lending their own money to people they know will pay them back). Couldn't be any worse than what we're now going through.

Matt - agree Rep. Paul has the correct diagnosis. However, I am sure you know, there is no shortage of those who want to make sure his diagnosis is never proven correct. Classic econ is no longer taught in school unless it is referenced akin to leeches in medical treatment.

Posted by: TXJim | Nov 13, 2008 5:58:58 PM

A case can be made that the CDS market was pure gambling - especially since the open interest far exceeded the total credit that could be insured. If one were to adopt a principle to prohibit gambling in equities (bucket shop laws, which we used to have), then regulation would have prevented the massive explosion of the government induced mortage market problems. That would have prevented the credit market meltdown, but not the deaths of Franny.

That many smart people missed this call is a case for adopting heuristics for preventing stuff like this, and enforcing them.

For example, one heuristic is requiring transparency (such as forcing the derivatives to be standardized and traded at exchanges).

This case was one where the free market ideology was totally wrong. Everyone missed it - in spite of the all the free market theories. That's pretty interesting.

I would be interested in you exploring the issue of how could all these smart, greedy people miss the opportunity to profit from this catastrophe. It's a mystery to me.

On that point... it was obvious that the housing market was in a bubble. Anyone with historic knowledge knew it was going to fall. But how many people knew how this was tied to subprime mortgages (which I had never heard of) and in general horrible lending policies. How many knew that and understood the CDO business and how the CDS's were tangled into it? Someone knowing all of this should have been able to predict the form of this disaster. Didn't anyone know this stuff?

Plenty of people knew about it. Andrew Lahde is one of the better known guys, if only for his very public eff you to the world when he walked away rich. There are a number of others who made billions though.

Everyone seems to be saying that "this case was one where the free market ideology was totally wrong." First of all, this wasn't anything close to a free market. Second, even if you want to call this a free market, the market losing value doesn't mean it's failed. The market loses value every 7-10 years. That's how 'free' markets work. Things go up, people realize they've gone up to high, things go down, people realize things have gone down to low, then they go back up again. When you get government heavily involved (as the have been in subprime loans, not only by mandating them but then by guaranteeing them) you generally get wider swings on either side. That doesn't say anything about failure.

The reason 'everybody' missed it, is because everybody isn't that smart, and everyone doesn't do their homework. On top of that, you can be smart and do your homework but mistime things by a month and lose all your chips. I guarantee you that happened to a lot of folks who would have made ungodly amounts of money, but they just called the top to early and got margin called, or their puts expired, etc.

Posted by: James | Nov 13, 2008 9:48:10 PM

I would point out that CDS are swaps, and so I think there is a winner for every loser -- it's a zero sum game. I be curious to see if anyone can demonstrate that it's not. John's point about Bucket Shops is interesting. I think the major difference between those and the current options markets are that margin is required now. That might have helped with swaps, but counter parties relied on credit ratings instead.

Posted by: Scott | Nov 13, 2008 10:35:21 PM

IIRC, the CDS game was actually pretty well on-top of all the risks involved. I read that the folks trading these securities were actively using the Mark-to-Market requirements, and the prices reflected the underlying values. The hype about these being a huge play by speculators was just hype. It took just a few days for this market to sort itself out, and they weren't bailed out by the Government.

Please correct me If I'm wrong about that.

Posted by: DaveK | Nov 14, 2008 3:30:53 AM

I would point out that CDS are swaps, and so I think there is a winner for every loser -- it's a zero sum game. I be curious to see if anyone can demonstrate that it's not.

Kevin posted a dialog with Felix Salmon where he claimed that the problem isn't that CDSes didn't pay up. It's that they brought companies down in two other ways: 1) the companies kept bad loans on their books thinking the CDSes made them profitable, 2) companies rated AAA did not have to issue collateral to issue CDSes. So when these companies (AIG) ran into trouble and lost their AAA rating, they went bankrupt trying to make the collateral.

Posted by: Noumenon | Nov 14, 2008 6:01:03 AM

There were, of course, plenty of people who recognized the housing bubble for the idiocy that it was (Alan Greenspan notably not one of them), but were there any major voices making specific policy proposals to slow down the bubble? Or rein in the mortgage market? Or regulate the CDO/CDS market in a way that would have prevented some of the damage?

I don't think these are the right questions.

The issue is not that there was a "bubble" that caused a lot of people to lose money. The issue is that somehow those losses became socialized. (Some would argue the expectation that the losses would be socialized is at least a partial cause of the bubble.)

So, we should not be asking "How could we have regulated things to prevent this bubble?" but "How can we regulate things to ensure bad outcomes associated with risk taking are internalized?"

Posted by: diz | Nov 14, 2008 7:45:18 AM

John Moore: "This case was one where the free market ideology was totally wrong."

Excuse me? What free market ideology have you read that advocates Government Sponsored Entities (GSE's) such as Fannie Mae and Freddie Mac? What free market thinkers persuaded Congress to demand that the GSE's expand lending to lower income, higher risk customers?

Posted by: John Dewey | Nov 14, 2008 8:05:16 AM

diz: "How can we regulate things to ensure bad outcomes associated with risk taking are internalized?"

These guys playing this game were searching for people to bet against them.

There are 2 sides to every trade, and right now, the US gov’t is the slumlord, thanks to Barack fucking Oblama.

Well done, shitbags, you just elected the least qualified, zero-clue pretty-boy pseudoeducated ambulance-chaser/community “organizer,” whatever that is.

I salute you! Have fun playing make-believe with your Oprah administration.

Fuck Kevin Drum. I’ll take the countertrade of that dumbfuck all day long….

Posted by: Mesa Econoguy | Nov 14, 2008 8:54:05 PM

Goddamn Drum left the italics on.

Yes, he is that stupid.

Posted by: Mesa Econoguy | Nov 14, 2008 8:56:50 PM

Since we’re blogging, what the fuck does this shit mean?

By the way, I'm typing this on the netbook I bought yesterday, an MSI Wind U100.

Who the fuck cares what you’re typing on as you write, other than you, Kevin? Are you that fucking pompous that you actually think we care how you transmit your economic ignorance to the web?

And you have the gonads to comment on high finance, amateur?

GFY.

Posted by: Mesa Econoguy | Nov 14, 2008 9:18:00 PM

This guy Drum is an absolute moron.

CDS/CDL/CMO need less regulation.

The major exposed risk (lately) is counterparty risk, and maximum risk mitigation for that is a centralized exchange, backed by a clearinghouse (not by a gov’t agency or otherwise).

There is no “transparency” with counterparties on things like option assignments or short covering buy-ins, but the exchanges have a vested interest in settled trades – it’s what they do.

Exchange-based pooled risk, backed by a clearinghouse, is the most liquid intermediary available. This will be sought out by remaining newly risk-averse entities, such as hedge funds.

No government entity can provide or guarantee complete trade settlement guarantee (as currently structured), which is ultimately why Lehman & Bear blew up, so we should be backing DTCC, OCC, and the futures exchanges instead of banks. Risk-aversion will self-direct remaining mkt. participants to exchanges – no regulation needed.

Sometimes there are none, and this appears to be one of those times, and the fact that you're looking for some tells me you have a reflexive proclivity to regulate, which will solve nothing. Idiots like Kevin Drum think there's an answer to every problem, and a government agency-in-waiting to step in anywhere and everywhere.

Kevin, do people actually pay you to write? This is some of the most childish horseshit I have ever read.

Anyone asking these kinds of questions in this manner has no business opining about the current financial mess (and we all know who Drum blames, and his pseudo-solution). He can't even get his terminology right. Pathetic.